Guest Interview:

Bennett Lawrence Management, LLC

Interview Quarter: 3Q1996

S. Van Zabdt Schreiber

Managing Member and Chief Portfolio Manager

Q: Tell us about your new company.

A: Bennett Lawrence Management, LLC was formed by four other individuals and myself who all worked together at C.J. Lawrence and its successor companies. We manage money for long term investors interested in significant capital appreciation. Our company offers two investment options to clients. We can be hired through either a traditional "Managed Account" relationship where investors will have their own separately managed portfolio consisting of 20-30 securities. Or, clients can invest in Bennett/Lawrence Partners, L.P., a commingled fund that gives us the ability to hold both long and short positions. We are currently managing over $600 million for a cross section of wealthy individuals, family offices, foundations, endowments, corporations, and non-profit institutions.

Q: Van, let's talk about your investment philosophy. What is it about the United State's economy compared with other world economies that makes the US such a uniquely favorable place to invest?

A: The United States differs from other countries in that its economy is extremely resilient and adaptable. It is also underpinned by the most efficient capital markets in the world. Investors around the globe have recognized this, adding both stability and liquidity to our markets. The absence of political risk has also made the US a desirable country to look for investment opportunities. At the corporate level, the adherence to Generally Accepted Accounting Principles makes financial comparisons much less arduous than in less established marketplaces. Corporate America's disclosure policies are among the best in the world and management teams are accessible to investors. Thus stability, liquidity, and access to reliable information are big plusses that to some extent offset the faster growth that from time to time can be found elsewhere. The shape of the United States economy also creates unique opportunities for growth investors. I have observed that since the early seventies economic growth in the US has been a very uneven affair with some industries moving ahead rapidly and others actually declining. So in my opinion, determining overall GDP growth in the United States is not nearly as important as identifying which areas of the economy are most likely to grow at a faster rate than the economy overall. Given the efficiency of our marketplace, capital is quick to gravitate toward the areas of exceptional economic strength creating a profitable business condition for the companies involved. Herein lies the heart of our investment process. We try to identify the major themes that present powerful investment opportunities and then select only those companies best positioned to benefit from these themes. The "we" I am referring to is Robert Deaton and myself.

Q: Please explain how you spot these overall economic trends.

A: Unfortunately, there isn't a simple answer to this question. The trends and themes are a crucial part of our investment process. We arrive at our investment themes by being alert to the world around us, by being intellectually curious and by reading extensively across a wide range of materials. We maintain constant dialogue with individuals that run companies engaged in a broad scope of businesses. In all of our discussions with corporate management, independent readings of trade journals, research, and regulatory filings we are trying to discern new trends and patterns. Over time, we arrive at conclusions about the flows of consumer spending, industrial spending or other significant capital movements. We try to be early and once we identify a trend, we move quickly to pinpoint the companies that participate. After we isolate a theme and identify the leading companies involved, we have ongoing conversations with the individuals that run the firms in which we invest. These contacts enable us to notice changes in the direction of these trends as they permute and create new opportunities. By keeping watch on the business conditions surrounding our companies, we are able to identify the new industries that are spawned to support the growth of the existing trends. This of course will present us with the next generation of leading companies.

Q: How about an example?

A: The trend toward managed care. In the mid-eighties, I believed that the HMO's had the collective skills to provide a low cost, private sector solution to the nation's health care problems. At that time, I invested in US Healthcare and later in Oxford Health Plans. As I grew to know the people running these companies, I found out about the amount of money they needed to spend on management information systems. This was an important area for the HMO's since it gave them the data management capabilities necessary to perform cost benefit analyses which helped control the costs associated with excessive usage and claims. Further, it enabled electronic data interface among physicians, hospitals and insurance companies. We thought this was intriguing and immediately looked at the companies that were providing management information systems to the health care industry. Sure enough, their order books were bulging and they were showing exceptional earnings. So you can see how the trend identification not only leads to powerful companies but also to new areas of growth investment.

Q: Why are these trends so important to your overall investment strategy?

A: We are growth investors with the objective of significantly above average capital gains. A strong trend obviously means an underlying thrust of increasing demand for the products or services of the companies involved. These trends will frequently last longer and have greater consequences than anyone would have thought at their inception. The end result is an earnings surge of dramatic proportions for the companies, their inevitable discovery by a large body of investors, and big upward moves in the stock prices. Looking for powerful trends is important for several reasons. This is an extremely disciplined framework for an investor to operate within. This means that we are only concerned with the healthiest, most vibrant areas of the economy. If we believe that certain sectors/industries have weak or lackluster prospects, we spend zero time looking at them for investment opportunities. Thus all of our time is spent learning about only those select areas of the economy that have real drive and staying power. We are not distracted by trying to figure out slow growth industries and mediocre companies. Secondly, the commitment to investing only in strong themes or trends adds an element of "adaptability" to our work. As the economy or business conditions change, so will the sector weightings of our portfolios. This insures that we keep the wind at our back and remain exposed to only the most dynamic industries and investment opportunities that exist.

Q: You believe in investing in leading companies that have competitive advantages. How do you know who is competitive?

A: We study the companies. We judge what it takes to succeed in that business and then determine who has the most of it - whether it is product development capability, marketing, low cost manufacturing - whatever. We also assess the energy, ability and commitment of management. It is often necessary to speak with competitors, suppliers and customers to reinforce beliefs and monitor the success of these companies. More often than not small to mid-sized companies with the right combination of management, new product capabilities and the use of technology are able to surpass their once larger competitors over relatively short periods of time. The rewards that accrue to this breed of company create windfalls for investors with minimal incidences of disappointment.

Q: Today's business world is so competitive that the pace of change is enormous. How do you stay informed and how do you go about analyzing constantly changing information?

A: You're right, the degree of change and the speed at which information is transmitted is incredible. The only way to stay on top is by being focused exclusively on a select number of distinguished industries within the economy. This is what we spend all of our time doing. To do this we try to develop knowledgeable sources within industries and stay in touch with them. We also use Bloomberg for up to the minute information on all of our companies. We receive timely information from Wall Street, attend conferences and participate in conference calls. Our primary research and company visits are also essential to our ability to stay informed. Not only do you have to know where investment change is taking place, but also how fast it is changing.

Q: How do you do this?

A: I find it most important to be very familiar with our companies and the people who are running them. We need to be able to pick up the phone and talk to informed individuals at our companies when there is "noise" in the market on a particular issue that effects them. Media and analyst hype often significantly overstate what is really going on. When this happens, it is our background knowledge of the companies and ability to reach out to reliable industry and company sources that determines whether we hold or fold. Tell us why the earnings results for companies are important to you.

Q: How is your analysis of earnings better than others when it comes to investing?

A: I have just found over the years that nothing else beats earnings progress - or the lack thereof - as a determinant of stock prices. This is not to say that earnings are the only thing or that good earnings always equal good stock market results. It's just to say that from my experience the trend in earnings is the best determinant of a stock's price. I think we are better than others at forecasting because we understand the dynamics better, the real impact of rising or falling prices, the consequences of increasing or declining plant operating rates etc. In analyzing companies, we pay close attention to the degree of operating leverage.

Q: When investing, how important is a company's asset size?

A: The company must be of sufficient size to really have a competitive advantage. This can vary a lot depending on the industry. We also need companies to have enough of a float so that its securities are marketable and liquid. We cannot invest in illiquid situations. More important than size is our belief that what lies ahead for the particular company is a rapidly growing market from which the company will be able to profit for years to come. Our ideal company is one that we can hold for 1-3 years and harvest between 2-5X our initial investment in profit. In general, these are nimble companies that tend to be mid-sized ($2-$3 billion market cap).

Q: How do you determine what percentage of portfolio assets to allocate to cash? What sources of information do you use to make these decisions?

A: In some of our portfolios we have been hired to remain fully invested. In most situations clients' have given us the authority to change their equity/cash weightings. For these portfolios we are not asset allocators in the true sense of the term. To judge our equity/cash mix, we will look at the Deutsche Morgan Grenfell "Market Monitor". The Market Monitor is authored by Jim Moltz, the Chief Investment Strategist at Deutsche Morgan Grenfell/C.J. Lawrence. I have known Jim for over thirty years and have a lot of respect for his ability to analyze the stock market. The Market Monitor is designed to anticipate the general direction of the market on a three month forward basis. We will use this to determine how much of our clients' assets will be invested in equities vs. cash in our managed accounts, or long positions vs. short positions in the case of our limited partnership. However, this is not a device for market timing. It is only used for broad allocation decisions. We are much better at finding terrific companies than trying to figure out the direction of the market and that is why we look at Jim's work. Although we are always invested, the cash component in our managed accounts could range from 5-30%, and in our limited partnership our exposure could change from net long to net short. If the Monitor's signal weakens, we will gradually raise cash (or short positions in Bennett/Lawrence Partners). If the Monitor's signal strengthens, we will add to positions or buy new companies (reduce short exposure). So, the Monitor will have a gradual effect on the amount of cash we have in accounts. This cash will be used to cushion our investors against rough periods in the market.

Q: Van and Robert, please tell us about your investment backgrounds.

A: Van: I have been an investor since I was 18 years old. I have always gotten a thrill from learning about businesses and trying to determine the factors that drive stock prices. I went to Williams as an undergraduate and then NYU for an MBA. After school I knew that I wanted to be involved with the stock market and went to work for Cyrus J. Lawrence, a Wall Street research boutique. I felt this would be an excellent opportunity to gain some real hands on exposure to the investment business. I began my career as a research analyst. Several years later I created an institutional marketing effort for C.J. Lawrence that increased their brokerage business substantially. I was always an active member of the investment policy committee, board of directors and executive committee. It was terrific to have a hand in the growth and development of C.J. Lawrence, we took it from a small securities research firm to one that was recognized globally and eventually acquired by Morgan Grenfell. Through these experiences, and by remaining a committed investor, I developed convictions about how the U.S. economic condition created profitable investment opportunities for growth investors. I then became involved with the Investment Management department at C.J. Lawrence, managing money in our current framework for outside investors. Robert: I began investing in the stock market at an early age. My father was an investor and he encouraged me to learn about investing by teaching me to read the stock tables. I later became involved with family business ventures. From this exposure I was able to recognize the difference that dedicated, competent management made to the success of a business. I received a B.A. degree from Davidson. After college, I worked at Merrill Lynch and then went to business school at Vanderbilt. While attending Vanderbilt, I began working for the State of Tennessee's Consolidated Retirement System as an intern. After graduating from Vanderbilt, I went back to the TCRS to become the portfolio manager responsible for the management of their long term growth fund. While working at TCRS, I was a research client of C.J. Lawrence's and was introduced to Van in 1994. We have both had experience in business beyond just investing in publicly traded companies and have similar notions on how value is created. Because I was looking for an opportunity to build upon my investment skills and Van needed help following companies, I decided to come up to New York and work with him.

Q: How did you to arrive at this method of investment analysis?

A: Van: Through all of my years as an investor I watched analysts, economists and strategists labor over predictions for real economic growth - almost as if, once they could get the correct real GDP number, all companies across all industries would be growing at that rate. I soon began to arrive at my own conclusions of how the economy worked. Real growth is not symmetrical. In fact it is erratic and uneven. There will always be industries with significant strength and others with poor prospects. If you look to invest only in these exceptionally strong areas you are sure to find terrific growth opportunities with low incidence of accidents. Robert: I have found that the best way to really understand the investment opportunity and the inherent risks associated with owning shares in a company is to do primary research. It is important to meet the people running the company so that you can determine whether they understand how to best exploit the market opportunity on behalf of the company's shareholders. You want to understand their vision and their motivation. You also want to see the company's facilities to learn about the people and products. It is important to read the company's regulatory filings. In these documents the company must disclose the uncertainty involved in their business. You cannot assess an investment opportunity without understanding business risks and competitive challenges. These documents are more explicit than Wall Street brokerage reports. Another major advantage of developing a rapport with company management is that they can serve as a source of information on other companies with which they deal or compete. For all of these reasons, I am a big believer that primary research is an essential ingredient in our success.

Q: What areas are each of you responsible for in the management of portfolios?

A: Van: We jointly figure out what needs to be done and then go do it. There are no committees or anything else to get in the way. I have ultimate responsibility for what is bought and sold in the portfolios. I also visit with companies, attend conferences, listen to conference calls and speak with Wall Street research firms. Robert: I spend all of my time staying on top of the companies. Since Van takes care of the daily portfolio management duties, I tend to spend a considerable amount of time on the road meeting with companies in which we have an interest. I do a large amount of primary research and then come back and talk my findings over with Van. Between the two of us we have thorough coverage of all of our companies and industries. We are extremely selective investors, and we are not easily convinced.

Q: How many companies do you usually consider as meeting your criteria and how many do you invest in of these?

A: We have a universe of 45-50 companies that have satisfied our investment criteria. Each company is on the receiving end of a significant economic trend or theme. They all must have current earnings gains that are at least 1.5-2X that of the market. Either Robert or I have met with the people that are running the company and we must be convinced that they will be able to maintain their competitive position for the foreseeable future. Individual portfolios will own some cross section of 20-30 of these companies.

Q: How long does it take for new client funds to be invested?

A: Depending on market conditions (and the client's parameters), it could take up to several months to become fully invested. We like to try to use the market's volatility to our advantage by investing in a timely manner for our new clients rather than just getting it all done the first day. What is your investment time horizon? If we correctly identify the theme and then invest in the most distinguished company, we can hold the positions for 1-3 years and hopefully make 2-5X our initial investment. If we make a mistake or if a company violates one of our sell disciplines, our investment time horizon becomes zero. Faster growing investments often mean higher risk.

Q: How do you limit risk?

A: We only invest in strong, profitable companies that lead their markets. Yes, they are growing rapidly. To us that makes them less risky than weak companies, laggards, turnarounds or financially troubled entities. We do not do turnarounds, derivatives, currencies, etc., or anything that hints of opportunism - the quick buck or fad. We also have several sell disciplines that help us control risk. When managing a portfolio, I will initially invest in 20-30 companies with each position representing 4%-5% of the overall account's assets. If an individual position grows in market value and becomes a 9% weighting in a portfolio I will automatically trim it back to a 5%-6% level. This prevents any one company from determining the fate of the entire portfolio. We will also monitor each company's discovery potential. We like it when our companies are not excessively known by other investors. This is desirable because as investors learn about a company, current owners are able to enjoy both an earnings play and multiple expansion. We don't like it when everyone knows about one of our companies and the future growth is discounted in the price. At that point we will sell and look for a more vibrant opportunity. We will also sell if we see competitors to our companies produce disappointing results. To us this is a signal that the industry we are involved in is becoming too competitive or the trend that it is benefiting from is loosing steam. We will also sell if one of our companies disappoints or its fundamentals begin to deteriorate. Through each of our sell disciplines, our insistence on current profitability and the Market Monitor, we are able to effectively manage risk. In Bennett/Lawrence Partners, our long/short limited partnership, the ability to sell short also reduces risk. You are a fast growing management firm.

Q: How is this growth going to affect investment performance?

A: If we fail to allocate our resources toward researching companies, then negatively. But we do not plan to fail at that. Additionally, our universe can handle a lot more money than we are currently managing. We are committed to performance and will do whatever is necessary to ensure that our investors' expectations are met. Hiring additional people and building a successful and profitable business are things that I have done in the past and look forward to doing in the future.